Trust: Four Studies on Innovation, Risk, and Market Dynamics in Decentralized Finance

This thesis is comprised of four studies on the role of trust in financial transactions, from 5,000 B.C. to contemporary cryptocurrency markets.

The first study (Chapter 3) evaluates the literature on the evolution of financial trust, tying it to modern advances in financial technology and decentralized finance. Most crucially, this chapter recounts the pre-modern use of ‘virtual’ currency, including via promises and orally traded stones. It also examines early proto-stablecoins, reinforcing how many of today’s financial needs–and early versions of contemporary solutions–existed in the past. It also demonstrates the extreme importance trust plays in financial transactions, and the many, many ways that trust is sought and demonstrated. From Roman Empire trade receipts created in ancient triplicate, to paper money in 7th Century China, as well as innovations which have long since vanished, financial innovation has long been an important part of every economy of note–and every successful innovation must be trusted to survive.

The following three studies examine contemporary cryptocurrency markets to further our understanding of trust at the frontier of contemporary finance.

The first of these cryptocurrency studies (Chapter 4) analyzes perpetual futures, a novel derivatives contract first proposed by Nobel Laureate Robert Shiller, but only fully implemented in cryptocurrency markets. In addition to looking at spillover effects between perpetual and traditional financial markets, this chapter examines the unique trust structure of perpetual futures–which on Binance includes socialized losses and a reserve fund denominated in cryptocurrencies–as well as 'funding rates', periodic payments between traders. It also tests arbitrage opportunities in Bitcoin quarterly futures, contributing to our understanding of market efficiency in cryptocurrency markets over time.

The next study (Chapter 5) examines the collapse of the TERRA/LUNA algorithmic stablecoin pair, analyzing contagion effects spread across markets, contributing to our understanding of how distrust spreads across cryptocurrency markets, while also testing trust in stablecoin issuers via market prices of issued assets. This chapter finds that traders have clear preferences for clearly defined, transparently-backed assets in a crisis. This is demonstrated by the market price of Tether, which traded at a 5% discount, while other stablecoins with more transparent and regulated reserve structures traded at a premium. Given Tether is supposed to trade for essentially $1 at all times, any non-minor deviation from the market price offers arbitrage profits to speculators, assuming they have faith in the underlying asset. That Tether traded at a discount for so long, while rivals traded at a premium, opens a window into trader behavior and the value of trusted and transparent reserve structures in a crisis.

The final study (Chapter 6) investigates the collapse of FTX, analyzing how contagion effects spread across markets during an exchange collapse. This study examines the price action of major cryptocurrencies stranded on the FTX exchange during a unique period where trading was allowed but withdrawals were almost entirely halted. This period provides insight into trader behavior and asset preference in advance of exchange bankruptcy. Major divergences between prices on FTX and the wider cryptocurrency markets were found, demonstrating how the unique pressure of an exchange collapse and withdrawal halt can dramatically influence market prices. The study examines an on-chain FTX-controlled Ethereum wallet, providing further detail about the FTX collapse while partially confirming FTX statements around the withdrawal halt. Verifying these statements, to the extent possible, was important as FTX was accused of fraud.

As a whole, this dissertation enhances our understanding of financial trust in contemporary digital markets, with empirical evidence demonstrating how contemporary financial challenges–from counterparty risk, identity verification, asset backing structures, market contagion, liquidity crises, and reputational risks–are enduring aspects of finance across eras. This research provides frameworks for evaluating market trust in novel financial asset classes while placing the contemporary decentralized financial space within the broader evolution of financial markets, highlighting the ways financial innovation can both create and destroy trust in value exchange.